Stocking Up On Storage

March 17, 2005

By Richard Stice, CFA Like many of its counterparts within the information-technology sector, the computer storage and peripherals subindustry has not had a banner year so far in 2005. In the year-to-date period through Mar. 11, the subindustry index has declined 9.4%, compared with a decrease of 1.0% for the Standard & Poor's 500-stock index. Nonetheless, we at S&P Equity Research have recently taken a more positive investment stance on the group.

Why? Our more positive outlook stems from the belief that spending on data storage will be a high priority in 2005. First, we see overall capacity growth rising due to the availability of more robust user applications, as well as the expanding use of the Internet and e-mail. Second, we anticipate new regulatory requirements associated with Sarbanes-Oxley legislation to result in a greater emphasis on data gathering, protection, and replication.

DATA LIFE. Finally, we see the concept of information life-cycle management (ILM) gaining acceptance in the marketplace. This idea is based on the view that different types of information have distinct lives and priority levels. Thus, ILM is designed to offer customers the ability to better manage data throughout its useful life, from its creation to its ultimate disposal. We believe as companies realize the value proposition of this service, storage firms will have additional opportunities to leverage their expertise.

Another facet of our improved view on the group is related to what we see as more favorable capital structures of industry players. Many companies have built up significant reserves of cash and investments, consistently generating free cash flow while maintaining what we deem to be low debt levels. We believe this provides them with ample flexibility to enhance shareholder value through strategic acquisition activity or the institution of stock repurchase programs.

A recently published report by research firm IDC indicated sales of external disk storage systems rose nearly 5% in 2004. The leading company in this category, EMC Corp. (EMC

PORTABLE POWER. While we continue to believe higher-end systems will provide a reasonable basis for revenue expansion, the consumer-device market has emerged as a critical new avenue of growth for the storage industry. This market encompasses a number of applications that are rapidly developing a mainstream following: notebook computers, digital set-top boxes, cellular phones incorporating digital cameras, portable digital music players, and a variety of other devices.

We think the advent of these new opportunities is a boon for the disk-drive industry, as it enables outfits to diversify their mix of business by devoting fewer resources toward the more mature desktop PC sector. We have 4 STARS (buy) recommendations on two companies within this segment of the storage market: Seagate Technology (STX

; $19) and Western Digital (WDC

; $12).

Due at least in part to the expanded use of disk-drive products, trends in the storage industry have improved notably over the past year. This is measured through the level of inventory currently on hand as well as by average selling prices. During its mid-quarter update earlier in March, Seagate noted that inventories were just slightly below its target range, and prices were expected to rise for the March quarter, in spite of what is typically a negative seasonal impact on demand -- and prices -- for its products. This compares with the year-ago period, when the industry was attempting to deal with excess inventory and declining prices as a result of aggressive discounting by participants.

CATALYST FOR GROWTH. We think Seagate has made significant inroads into the consumer arena and is one of the primary providers to this market. We project revenue growth of 14% in fiscal 2005 (ending June), to $7.1 billion, and of 10% in fiscal 2006, to $7.8 billion. Our operating earnings-per-share estimates for these years are $1.04 and $1.64, respectively. Our 12-month target price of $23 is based on

In late January, we upgraded the shares of Western Digital to 4 STARS from 3 STARS (hold). Our move came the day after the company's announcement of a new product launch addressing the one-inch hard-drive market, which caters to various handheld consumer goods. We believe the offerings, scheduled to begin shipping during the June quarter, provide a clear catalyst for future growth.

For Western Digital, we forecast revenues of $3.6 billion in fiscal 2005 (ending June) and $3.8 billion in fiscal 2006. Our corresponding operating earnings per share estimates are 71¢ and 91¢. We derive our 12-month target price of $16 from a combination of DCF and relative price-to-earnings analysis.

EYE ON INVENTORY. Given what we see as favorable market trends, quality business strategies, and attractive valuations, we advise purchase of Seagate and Western Digital shares.

Risks to our recommendations and target prices include a pronounced decline in average selling prices, a buildup of inventory levels in the distribution channel, and an inability to keep up with changing technological trends.

Note: Richard Stice has no stock ownership or financial interest in any of the companies in his coverage area. All of the views expressed accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com

Required Disclosures

5-STARS (Strong Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of Dec. 31, 2004, SPIAS and their U.S. research analysts have recommended 26.5% of issuers with buy recommendations, 61.3% with hold recommendations and 12.2% with sell recommendations.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, New York, NY 10041.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sublicense by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's. Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.

Disclaimers

This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions, and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities, financial instruments, or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations, or needs and is not intended as a recommendation of particular securities, financial instruments, or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Analyst Stice follows shares of computer storage & peripherals companies for Standard & Poor's